As we move into 2008, the focus of attention for global capital markets continues to be the problems associated with the American mortgage markets, where a number of banking groups have made further provisions against their lower quality debt.  At the same time, several international banks have sought to raise additional capital from sovereign wealth funds in order to rebuild their balance sheets.  Interest rate policy both in the US and the UK has proved accommodating to market conditions and we expect a trend towards lower rates to continue into 2008.  Inflation in the UK does remain a concern given the sharp fall in sterling that was seen in the last quarter of 2007, but the weakening UK housing market and poor outlook for retailing tips the balance, in our view, towards rates softening over the next three to six months. 

Currency markets became somewhat more volatile towards the end of 2007 and we believe that sterling is firmly on a downward track on a trade-weighted basis.  Both the fiscal balance and trade balances of the UK economy are heavily in deficit which, at this stage of the economic cycle, leads us to believe that currency markets will focus their attention more closely on the level of sterling against most major currencies. 

Global oil markets continue to remain very tight and we see few catalysts to bring the oil price down a great deal.  The gold price, too, has remained at relatively high levels as a result of uncertain global economic growth and political instability in the Middle East and, latterly, in Pakistan.  Some hard commodity prices have trended back but, given the sharp rises that we have seen over the past three or four years, some pull-back is to be expected from time to time.  We remain firmly committed to the view that we are in a commodity ‘super cycle’ and that the strategic needs of China for raw materials will remain a factor in the pricing of such commodities for the foreseeable future.

In bond markets, credit spreads – or the additional yield demanded by investors to invest in corporate bonds rather than sovereign issues – remain at high levels compared with the experience of the past two or three years.  In the UK, the gilt market made progress as expectations of further cuts in interest rates by the UK authorities grew towards the end of the year.

Turning to global markets, the economy in Japan has continued to stagnate, although inflation is now in positive territory for the first time in several years.  This has unfortunately been as a result of rising energy and input prices rather than a consumer-led recovery.  In the long term the Japanese market will, we believe, recover as consumers diversify their substantial holdings in bonds and cash into equities, but the timescale for this is likely to be somewhat protracted. Pacific Rim markets tracked back a little towards the end of 2007 but the prospects for growth in this area, and in particular from China, still appear robust.  As we have pointed out, a sharp spike in the oil price or global political instability could derail this process but global investment funds, seeking growth opportunities, will look to diversify towards these markets and away from more traditional developed markets. 

In the United States, equity markets have been quite robust given the turmoil in credit markets and the sharp adverse move in sentiment towards housing in general.  We feel that the American economy will avoid moving into recession during 2008, although this could be a near-run thing in the first half of the year.  In particular, the Federal Reserve has shown itself to be accommodating in terms of its policy responses regarding interest rates, and it is to be expected that rates will fall further to offset recessionary influences.

In the UK, a fall in the value of sterling has potential beneficial effects for the level of the equity market given the substantial foreign-exchange profits earned by our major companies and the fact that a fall in sterling makes UK assets relatively cheaper for foreign corporate predators.  Against the background of falling interest rates which we envisage for the first part of 2008, and notwithstanding the problems in the banking and credit markets, this would tend to be a more supportive environment for equities to regain some attraction.  We foresee a slowdown in the UK economy and we also expect some slowing in the rise of corporate earnings during 2008, but it is our feeling that some fall in overall corporate profitability has already been factored into market ratings.  Additionally, the corporate sector is generally well financed and we expect some pick-up in merger and acquisition activity to take place in 2008, although the ability for private equity firms to finance debt-based acquisitions will be severely curtailed by the current capital market conditions. 

In Euroland, it has been pleasing to note the strong performance of the German equity market during 2007 and we expect this to continue during 2008.  Germany remains the key pick amongst the Euroland economies and we expect France and Italy to make sluggish progress at best during the early part of the year.  The fallout of the global credit crunch will in our view continue to have a negative impact in both Spain and Ireland, where growth may be severely curtailed.

Turning to our investment themes, we continue to reiterate our enthusiasm for commodity related stocks and it remains our belief that large capitalisation companies will tend to do better than middle and small caps.  Although there may be some crimping of demand for global luxury goods in the current environment the fact that a number of our key stocks are denominated in currencies other than sterling leads us to maintain weightings in this area.  We continue to favour holdings in equities over fixed interest but seek to retain moderate cash balances to take advantage of investment opportunities as and when they occur.  Overall, despite the gloomy background surrounding global markets for the past few months, it has been pleasing that equity markets have remained as resilient as they have and with the expectation of interest cuts in the first few months of 2008 we feel that prospects for markets will gradually brighten as the year progresses. 

On a global perspective, we believe that the continuing growth of Pacific Rim, China and developing countries such as Brazil and Russia will continue to counterbalance the slowdown in growth from the developed world.  We expect the so-called sovereign wealth funds – the funds of governments of oil-rich countries and the Far East – to assume a more important strategic role in global capital markets throughout the year.  As we have previously noted, debt-financed acquisition activity will be severely constrained by current credit conditions but the opportunities thrown up by some weakness in capital markets may be sufficient to tempt well-financed companies to pick off their weaker brethren as the year progresses.



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